August 29, 2016 | BY Shulem Rosenbaum
Your Inheritance Is At Risk: Uncle Sam Wants a Bigger Piece
Elvis Presley may still be alive, but the Internal Revenue Service collected a whopping 73% of his estate in taxes. Financial titans and politically connected men such as J.P. Morgan, John D. Rockefeller Sr. and Frederick Vanderbilt lost a significant majority of their wealth due to estate shrinkage. All this was a result of poor estate planning. Estate planning allows an individual to transfer wealth during his life and after his death with the least possible negative tax consequences. There are various devices used to transfer property to family and friends, and an essential tool for estate planning are the valuation discounts. However, on August 2, 2016, the Treasury Department published Proposed Regulations that may substantially reduce the availability of valuation discounts for estate planning purposes.
What is estate planning?
Estate planning involves devising financial strategies to ensure that the decedent’s wishes are honored with respect to transferring property and business succession. In addition, an advisor can plan the transfer of property in a way that it can avoid the arduous probate process and reducing estate shrinkage by reducing the tax burden. An effective estate plan can be made by means of gifting the assets or transferring property to a trust during the lifetime of the transferor.
What is estate tax?
The unified federal transfer tax is a tax that is imposed on the transfer of wealth. The fair market value of an estate is subject to a tax of up to 40%, with an exemption amount of $5,450,000 for 2016 (indexed for inflation). In addition, a donor is liable to pay taxes on gift transfers during his or her lifetime in excess of the annual exclusion of $14,000. However, a gift splitting election allows married spouses to give away an amount up to twice the annual exclusion to a donee without paying gift taxes.
What is fair market value?
Estates and gifts are taxed on the fair market value of the transferred assets. Accordingly, transferred assets must be appraised to determine its value. The IRS (Revenue Ruling 59-60) defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
What are valuation discounts?
Valuation discounts reduce the fair value of an asset and can thus significantly diminish the tax burden. In addition, assets may be discounted to an extent so that it would not exceed the exemption amount. The two primary discounts are the discount for lack of control (also known as the minority discount) and the discount for lack of marketability (also known as the liquidity discount).
Discount for Lack of Control
The discount for the lack of control occurs when a transferor transfers minority interests in S corporations, family limited partnerships or limited liability companies. In theory, a person owning a 100% interest has greater control over the entity operations and would have a greater value than a person owning 51%, or limited control. This limited control is a result of having a partner or partners who must agree with business management decisions that require unanimous consent. Hence, the minority discount reflects the lack of control which includes the inability to appoint management or set policies, authorize acquisitions and liquidations of assets, or make fundamental changes. Thus, the IRS states: “In valuing the stock of closely held corporations, or the stock of corporations where market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes.” In addition, if the transferor imposed restrictions on the transfer of the assets then a minority discount is warranted. In Cravens v. Welch the Court rules that “…no consideration is given to the very apparent fact that minority stock interests in a ‘closed’ corporation are usually worth much less than the proportionate share of the assets to which they attach.”
Thus, the minority discount became a popular estate planning vehicle with the assets being discounted by 10% to 40%. For example, if Individual A owns an LLC with a net worth of $100 million, he can transfer a 10% interest ($10 million) at a 40% discount, or $4 million, to save $1.6 million in Federal gift tax.
Discount for Lack of Marketability
The fair value of a publicly-traded stock assumes that members can liquidate their investment and convert it into cash in a reasonable amount of time. However, interests in non-marketable, closely held investments, with no established markets complicates their conversion into cash. Accordingly, a discount for the illiquidity of the investment, or lack of marketability, can be assumed. The SEC (Accounting release No. 113) states: “Restricted securities are often purchased at a discount, frequently substantial, from the market price of outstanding unrestricted securities of the same class. This reflects the fact that securities which cannot be readily sold in the public market place are less valuable that securities which can be sold.” Indeed, studies of restricted stock of public companies, pre-IPO studies, and merger and acquisition studies indicated an historical illiquidity discount of 10%-50%. This discount, taken in seriatim with the minority discount, can result in a substantial reduction in the value of gifted or inherited assets.
To address the fact that taxpayers were imposing restrictions on transferred interests in order to artificially reduce the value of assets for gift tax purposes, the Treasury Department published Proposed Regulations to Chapter 14 of the Internal Revenue Code. The Treasury Department did not like the fact that gifts were structured in a way that assets were divided between multiple family members or contain restrictions in order to trigger the minority discount. Accordingly, the proposed regulations – once enacted – will substantially limit the valuation discounts if the transferor or a related party – including members of the transferor’s family or an entity holding interests for such persons – can collectively remove or override those restrictions. Thus, family-controlled entities with business governance documents that contain restrictions that can be reversed or amended by family members or related entities (acting in unison, if necessary) will have limited use of valuation discounts.
Nevertheless, the Proposed Regulations must undergo a 90-day comment period and a public hearing is scheduled for December 1, 2016. Any final Regulations issued after this comment period will go into effect only 30 days after those final Regulations are published. Accordingly, it is now time to act and plan your inheritance in order to minimize the tax burden on your estate.
Roth & Co.’s Trusts and Estates Team can assist you with all of your estate planning needs, including business succession planning, Medicaid planning, and trusts and estate planning. Speak to your account representative for more information, or contact an accountant today at 718.236.1600 to schedule an appointment.
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